Berkshire Hathaway
The Impact of SIZE on Buffett's Philosophy

Format for Printing

Format for printing

Request Reprints


By FreeCashFlow
January 16, 2002

Posts selected for this feature rarely stand alone. They are usually a part of an ongoing thread, and are out of context when presented here. The material should be read in that light. How are these posts selected? Click here to find out and nominate a post yourself!

In his earlier days, Warren Buffett used Benjamin Graham's philosophy, which consisted of buying stocks when they were very cheap and then selling them when they were no longer cheap. Today, Buffett prefers to buy quality, is willing to pay more for quality, and prefers to avoid selling even after the price has caught up to the value. One sure sign of his shift: Although the stock market is MUCH more expensive today than it was in 1969 (when he liquidated the Buffett partnership), he is NOT liquidating Berkshire Hathaway's stocks.

Part of his shift is due to the poor economics of the textile and other wormy businesses he owned, and part of Buffett's shift is due to the influence of Charlie Munger and Phil Fisher.

Another reason for his shift is the fact that he considers the management of his companies to be close friends and associates. To most of us, the upper managements of the companies we hold stocks in are strangers.

However, I think there is another reason behind Buffett's change: He has too much money to work with. In 1969, his partnership only had $100 million in assets. Berkshire Hathaway today has over $100 billion in assets, or more than 1000 times as much capital to work with. Berkshire owns a significant percentage of the shares outstanding in a particular stock, even for a giant company like Coke. Selling $10,000 or even $1 million of Coke is easy. But selling $10 billion of Coke stock is MUCH more difficult. Buffett cannot simply log into his Vanguard Brokerage account, place an order to sell all 200 million or so shares, and expect to be out of Coke by lunchtime. Daily volume is under 4 million shares. In order to avoid impacting the price, Buffett would have to restrict his trading volume to a small fraction of the total volume. Buffett is an elephant today, while he was a mouse in 1969. Just as a mouse can maneuver through crevices an elephant wouldn't even notice, the Warren Buffett of 1969 could do many things that the Warren Buffett today cannot do.

I think this size factor has heavily influenced Buffett's investment style. Since it is exceedingly difficult for him to bail out of a stock, he MUST be extra-snooty about the quality of the businesses. Berkshire's sheer size limits Buffett to large-cap companies. A $1 billion position is only 1% of Berkshire Hathaway's assets. Even a double in such a position would only add about 1 percentage point to Berkshire's return. The result: Buffett is limited to high-quality large-cap stocks, and he has to be willing to pay higher multiples. Also, the illiquidity of his positions makes it MUCH more important that he avoids anything other than the VERY VERY VERY best stocks.

One reason that Graham wasn't as selective with respect to quality is that he never managed a very large portfolio. I think I read in one of John Train's books that he refused to manage more than $20 million (perhaps $200 million in today's money).

My philosophy is a hybrid of Buffett and Graham. Reading about Buffett convinced me of the importance of quality. Using free cash flow instead of earnings, book value, and dividends as my valuation yardstick makes it easier to see which companies are high quality and which are low quality. Low quality companies may have a generous amount of assets and earnings but lack free cash flow. However, I still agree with Graham's insistence on a rock-bottom price/value ratio. As a financial microbe (as opposed to a mouse like Buffett in 1969), I can accumulate a meaningful amount of any stock I want, and the daily volume will easily accommodate me. While I'm not an active trader, I do expect in the future to turn over an average of 5%-10% of my portfolio per year. This is still a low turnover rate (perhaps one-tenth that of the average mutual fund) - it would take me 10-20 years to buy and sell every stock in my portfolio (if I were fully invested and had at least 10 stocks).

Of course, if I become as successful as Buffett, I'll have to change my investment philosophy eventually to accommodate my portfolio's sheer size.


TMF Money Advisor
Got money questions? Your answers are just a phone call away! TMF Money Advisor puts you in touch with an objective Financial Planner whenever you need it.